Advertisement

You Can’t Time The Market?

Brett Arends recently wrote a piece for the WSJ discussing the “Market Timing Myth” which primarily focused on several points that I have been making for years but most recently in ourlast weekly newsletter. Brett really hits home with the following statement:

“For years, the investment industry has tried to scare clients into staying fully invested in the stock market at all times, no matter how high stocks go or what’s going on in the economy. ‘You can’t time the market,’ they warn. ‘Studies show that market timing doesn’t work.’

He goes on:

“They’ll cite studies showing that over the long-term investors made most of their money from just a handful of big one-day gains. In other words, if you miss those days, you’ll earn bupkis. And as no one can predict when those few, big jumps are going to occur, it’s best to stay fully invested at all times. So just give them your money… lie back, and think of the efficient market hypothesis. You’ll hear this in broker’s offices everywhere. And it sounds very compelling.

There’s just one problem. It’s hooey.

They’re leaving out more than half the story.

And what they’re not telling you makes a real difference to whether you should invest, when and how.

The best long-term study relating to this topic was conducted a few years ago by Javier Estrada, a finance professor at the IESE Business School at the University of Navarra in Spain. To find out how important those few “big days” are, he looked at nearly a century’s worth of day-to-day moves on Wall Street and 14 other stock markets around the world, from England to Japan to Australia.

Yes, he found that if you missed the 10 best days you missed out on a lot of the gains. But he also found that if you managed to be out of the market on the 10 worst days, your profits went through the roof.

Over an investing period of about 40 years, he calculated, missing the 10 best days would have cost you about half your capital gains. But successfully avoiding the 10 worst days would have had an even bigger positive impact on your portfolio. Someone who avoided the 10 biggest slumps would have ended up with two and a half times the capital gains of someone who simply stayed in all the time.

In other words, it’s something of a wash. The cost of being in the market just before a crash are at least as great as being out of the market just before a big jump and may be greater. Funny how the finance industry doesn’t bother to tell you that.”

The reason that the finance industry doesn’t tell you the other half of the story is because it is NOT PROFITABLE for them. The finance industry makes money when you are invested – not when you are in cash. Therefore, it is of no benefit to Wall Street to advise you to move to cash.

Now, let me clear. I do not strictly endorse “market timing” which is specifically being “all in”or “all out” of the market at any given time. The problem with market timing is consistency. As I stated in this past weekend’s missive:

“You cannot, over the long term, effectively time the market. Being all in, or out, of the market will eventually put you on the wrong side of the ‘trade’ which will lead to a host of other problems. “

I do suggest applying some analysis to your portfolio to measure the inherent “risk,” which is short for “how much money you will lose when you are wrong,” within your portfolio relative to the markets and adjust your portfolio allocation like a “rheostat” rather than a “light switch.” As I discussed:

“As a long term investor I am not interested in the day to day price movements of the market but rather the ‘trend’ or ‘direction’ of the market. Since all asset prices are primarily driven by the direction, or trend, of the market – getting the trend right is literally ‘90% of the battle.’

Our portfolio allocation model is driven by the overall market analysis which consists of a ‘Warning Signal’, two ‘Sell Signals’ and a ‘Trend’ Signal. The ‘Warning Signal,’ which was issued a couple of weeks ago, just meant that we should pay attention to our portfolios and do some ‘maintenance’ by taking profits and reducing laggards.

Each subsequent signal requires a 25% reduction in the equity allocation model. This means that the portfolio will never have less than 25% of its recommended target equity allocation as there are only three signals which would lead a maximum reduction in equity holdings of 75%. This is because we always want to keep some low risk equity exposure in the markets at all times, since markets cannot be consistently timed, but the reduction in risk protects the portfolio from catastrophic declines.

The chart below shows the progression.

As each signal develops the risk to the portfolio comes from the exposure to the equity market. Therefore, by reducing the exposure to the market – the capital of the portfolio is protected from the ensuing decline.”

As you will notice I never suggest that you are 100% out of the market. The problem with being completely in cash is overriding the emotional biases that lead us to “buy high” and“sell low.” However, by using some measures, fundamental or technical, to reduce portfolio risk by taking profits as prices/valuations rise, or vice versa, the long term results of avoiding periods of severe capital loss will outweigh missed short term gains. Small adjustments can have a significant impact over the long run.

Brett made some great points in this regard as well as on the importance of dividend income to long term portfolios:

“First, let’s be clear what it doesn’t mean. It still doesn’t mean you should try to ‘time’ the market day to day. Mr. Estrada’s conclusion is that a small number of big days, in both directions, account for most of the stock market’s price performance. Trying to catch the 10 biggest jumps, or avoid the 10 big tumbles, is almost certainly a fool’s errand. Hardly anyone can do this sort of thing successfully. Even most professionals can’t.

But, second, it does mean you that you shouldn’t let scare stories dominate your approach to investing. Don’t let yourself be bullied. Least of all by someone who isn’t telling you the full story.

Third, it offers yet another argument in favor of investing for dividends, not simply for capital gains. Most of these ‘market timing’ studies, including Mr. Estrada’s, focus purely on stock market price movements. They ignore dividends. (The reason is technical. Reliable total return data is hard to find once you go back more than a few decades. And calculating the interaction between daily price movements and reinvested dividends is a heroic undertaking.)

But the omission of dividends matters for shareholders. That’s because dividends are likely to make up a significant bulk of your long-term returns. And you know when your dividends are coming. You don’t have to guess on which days, if any, AT&T or Johnson & Johnson will send out checks.

Over long periods, a strategy focused on good dividend-paying stocks has usually proven successful. You don’t know what the stock market is going to do in a week on Thursday, but this way you don’t really care either.

Fourth, even if there is little point trying to catch twist and turn of the market, that doesn’t mean you simply have to be passive and let it wash all over you. It may not be possible to “time” the market, but it is possible to reach intelligent conclusions about whether the market offers good value for investors.

There is a clear advantage to providing risk management to portfolios over time. The problem, as I have discussed many times previously, is that most individuals cannot manage their own money because of “short-termism.” Despite their inherent belief that they are long term investors they are consistently swept up in the short term movements of the market. Of course, with the media and Wall Street pushing the “you are missing it” mantra as the market rises – who can really blame the average investor “panic” buying market tops and selling out at market bottoms.

Yet, despite two major bear market declines, it never ceases to amaze me that investors still believe that somehow they can invest in a portfolio that will capture all of the upside of the market but will protect them from the losses. Despite being a totally unrealistic objective this“fantasy” leads to excessive risk taking in portfolios which ultimately leads to catastrophic losses. Aligning expectations with reality is the key to building a successful portfolio. Implementing a strong investment discipline, and applying risk management, is what leads to the achievement of those expectations.

As Mr. Arends concludes:

“Can’t time the market? It was clear as a bell that investors should have gotten out of stocks in 1929, in the mid-1960s, and 10 years ago. Anyone who followed the numbers would have avoided the disaster of the 1929 crash, the 1970s or the past lost decade on Wall Street. Why didn’t more people do so? Doubtless they all had their reasons. But I wonder how many stayed fully invested because their brokers told them ‘You can’t time the market.”‘

About The Author

After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.